Flashcards in Decision Making Deck (65):
What are the three elements of production?
(1) direct materials (DM) = materials that end up composing the finished product and can be easily traced to the finished product
(2) direct labor (DL) = labor that acts directly on the product to transform direct materials into finished products and can be easily traced to the finished product
(3) manufacturing overhead (MOH) = all other production costs, i.e. costs that cannot be traced easily to a finished product
-also called factory overhead, indirect factory costs
What kind of things can be included in manufacturing overhead (MOH)?
(i) indirect materials and labor -- can't be traced easily to finished product
(ii) factory utilities
(iii) wages/salary for maintenance workers or managers
(iv) factory machinery and depreciation
Is overtime pay for direct laborers considered to be direct labor or manufacturing overhead?
Manufacturing overhead -- the rationale is that overtime costs are to be attributed not simply to the extra products created, but to the total volume of products, since that is what requires overtime
What elements are included in conversion cost?
It is the cost to convert direct materials to a finished product, so it involves (a) direct labor and (b) manufacturing overhead
What elements are included in prime cost?
It includes all costs easily traceable to finished products, so it involves (a) direct materials and (b) direct labor
What is the difference between product costs and period costs?
Product = all costs related directly or indirectly to physical products, and thus included in inventory
-recognized as the cost of goods sold when physical products are sold
Period = not directly or indirectly related to physical products, e.g. G&A expenses and selling expenses
-recognized in the period when the cost is incurred
What are different ways that costs can be categorized?
(i) traceability -- whether they can be traced to finished products
(ii) behavior -- whether fixed or variable
(iii) function -- what they do within the business, e.g. selling costs
(iv) object of expenditure -- what goods or services they purchase, e.g. wages, advertising expense
(v) controllability -- whether managers can influence the amount of the cost (within a given amount of time)
What are two different kinds of fixed costs?
(1) committed = related to long-term assets and equipment that have a cost independent of production volume
(2) discretionary = related to activities budgeted to occur by management whose cost is independent of production volume, e.g. R&D costs and advertising costs
How does a measure of total fixed cost (TFC) compare to a measure of average fixed cost per unit (AFC)?
TFC will always be a constant, while AFC will be decreasing as production volume increases
Specifically, the graph for AFC will have a convex negative slope -- it will bulge towards the origin
How does a measure of total variable cost (TVC) compare to a measure of average variable cost per unit (AVC)?
TVC will steadily increase as production volume increases, while AVC will be a constant amount
TVC will have a constant positive slope -- not convex or concave
What are mixed costs?
Costs with both fixed and variable components (thus called semivariable), since they vary with total production but are not zero for zero production, e.g. electricity and maintenance
These can sometimes be split up into their variable and fixed components to simplify calculations
What are step-variable costs?
Costs that are fixed within specific ranges of input, but have specific points at which the cost "steps up" to the next level -- so the total-cost graphs for these look like stair steps
E.g. if supervisors are needed for every 20 factory workers, then the supervisory cost would be fixed for the first 20, be twice as much for 21-40, be three times as much for 41-60, etc.
Generally speaking, how do total costs and average costs relate to volume?
Total = directly
Average = inversely
How do learning curves relate to labor productivity and labor costs?
Because workers get better at their job than when they first start, they will be able to produce more products as they gain experience
Thus labor costs will go down per unit produced as time goes on (though there will be a limit to this)
What is an experience curve?
Very similar to a learning curve, except that it relates to a group rather than individuals -- refers to how well a given group can perform a task as a firm or within a firm, e.g. how well an assembly line can work together to efficiently complete their segment of the production process
What is the main difference between a manufacturer's income statement and a merchandiser's income statement?
The manufacturer's statement includes a cost of goods manufactured used to calculate the cost of goods sold, rather than calculating it from beginning inventory, purchases, and ending inventory
Cost of goods manufactured = cost of goods that are completed and moved to the inventory of finished goods
What is the overall structure for a cost of goods manufactured schedule?
Beg. work-in-process (WIP)
+ manufacturing costs incurred
= total manufacturing costs
- ending WIP
= cost of goods manufactured
Within the cost of goods manufactured schedule, how are the "manufacturing costs incurred" measured?
Direct materials (DM) used
+ direct labor (DL) used
+ manufacturing overhead (MOH)
= manufacturing costs incurred
Within the calculation of manufacturing costs incurred, how are direct materials (DM) used measured?
Beginning balance of DM
= DM available for use
- ending balance of DM
= DM used
Within the calculation of manufacturing costs incurred, how is direct labor measured?
Not with any special schedule -- just measured as the total wages paid to the relevant workers, usually a single given amount
Within the calculation of manufacturing costs incurred, how is manufacturing overhead measured?
+ indirect labor
+ misc. manufacturing costs
How is work-in-process inventory calculated?
Beg. balance of WIP
+ material, labor, and MOH used
= goods available to finish
- goods finished
= ending balance of WIP
How is finished goods inventory calculated?
Beg. balance of FG
+ goods finished (from the WIP schedule)
= goods available for sale
- cost of goods sold
= ending balance of FG
What is cost-volume-profit (CVP) analysis?
Sees how different decisions impact cost, volume, and profit, and is especially concerned with break-even points, i.e. at what point of volume revenues overtake costs (thus it is also called break-even analysis)
What are some assumptions of CVP analysis?
(i) costs are properly classified as either fixed or variable (e.g. there is a relevant range over which fixed costs do not change)
(ii) production efficiency is constant
(iii) inventory is constant (production = sales)
(iv) volume is the only relevant thing affecting costs
(v) the sales mix of multiple products is constant
(vi) costs and revenues are linear over the relevant range
What does a CVP chart generally look like?
With units of output on the x-axis and dollars on the y-axis, a P/V chart shows positive-sloped lines for sales and total costs at given levels of output
At any given point of output, the profit (or loss) is the difference between the sales and total cost -- and the point of intersection is the break-even point
CVP charts also include a (horizontal) line for fixed costs and a line for variable costs (parallel to total costs)
What is contribution margin?
Contribution margin = sales - variable costs
Thus the contribution margin on a CPV graph can be measured as the distance between sales and variable costs
What does a profit/volume (P/V) chart generally look like?
Whereas a CVP graph plots sales and total costs, a P/V chart plots income (i.e. sales - total costs) alone
The x-intercept of the income line would be the break-even point (i.e. where income is zero), and the y-intercept would show the fixed costs (i.e. costs where production is zero)
Moreover, the slope of the income line would be the unit contribution margin, since it would represent the unit increase in sales minus the unit increase in cost
What is the contribution margin ratio?
The contribution margin (sales - variable costs) divided by sales
This can be unit CM / unit sales or total CM / total sales
What is the variable cost ratio?
Variable cost / sales
How can the contribution margin be used to calculate the break-even point in units?
Fixed costs / unit CM
Since the unit CM is the amount of profit earned with respect to variable costs only, then this measures how many units have to be sold for such a profit to overtake fixed costs
How can the contribution margin be used to calculate the break-even point in dollars?
Fixed costs / CM ratio
Since the CM ratio measures the % of each sale that exceeds the variable cost (i.e. the % of each sale which is a profit with respect to variable costs), then this ratio measures how much $ in sales a firm needs in order to overcome fixed costs, given that it can apply a particular amount of each sale to its fixed costs
How does the calculation of a break-even point in units or dollars relate to a calculation for a level of desired profit?
Because (fixed costs / unit CM) gives the break-even point in units, and because (fixed costs / CM ratio) gives the break-even point in dollars, a firm can also calculate the required sales (in units or dollars) for a desired level of income simply by adding that income to the numerator
E.g. (fixed costs + desired profit) / unit CM = # of units needed to achieve desired profit
What are the two different methods for solving for break-even points?
(1) income equation method
(2) contribution margin method
(1) involves a commonsense knowledge of how income is calculated (sales - fixed costs - variable costs), while (2) involves the formulas for contribution margin
Basically, it is just important to know how to calculate the break-even point given the available information, which could be limited
How can break-even analyses become more complicated?
When they are used to determine a composite break-event point for the sales of multiple products with a particular sales mix
The only difference in calculation for this is that a composite contribution margin must be calculated
For multiple products in a sales mix, how is their composite contribution margin calculated?
As the weighted average of each individual product's contribution margin
For instance, in a "package" of 2 X products, 1 Y product, and 3 Z products, the composite CM would be (2 x X's CM) + (1 x Y's CM) + (3 x Z's CM)
How does a composite contribution margin relate to the calculation for a sales mix's break-even point?
The composite CM can be used to calculate how many "packages" need to be sold, which then can be multiplied out to determine the break-even point in individual units or $
E.g. for a package of 2 X products, 1 Y product, and 3 Z products, if the break-even point is 5,000 packages, then the break-even quantity would include 10,000 of X, 5,000 of Y, and 15,000 of Z -- and the break-even point in $ would be those amounts multiplied by their sales prices
Besides problems involving particular sales prices, variable costs, etc., what can CVP analysis help to solve?
Problems involving changes in such values
These are generally presented in relation to already-given values, in which case you just need to calculate the new values and use the same formulas
These types of problems can vary, e.g. problems to solve for a change in sales price given a change in variable cost but a desire for the CM to remain the same
If using CVP to calculate the point at which the firm will achieve a desired income (rather than just a break-even point), how would income taxes affect the calculation?
The firm would need to know the amount before taxes were subtracted, which means it would have to divide the desired income by (1 - tax rate)
What is a firm's margin of safety (M/S)?
The amount of sales it has beyond the sales needed to break even
M/S = total sales - break-even sales
M/S in units = total units sold - break-even units sold
Can a firm's margin of safety (M/S) be expressed as a percentage?
Yes, by dividing the M/S by total sales (or total units sold, if dealing with units)
When making a special business decision, what are the relevant costs one must consider?
Only costs that impact future cash flows, not sunk costs, no matter how great those sunk costs are
Moreover, only differences in future cash flows among alternatives matter; if certain costs are unavoidable, then they are irrelevant to the decision
What is a special order decision?
A business decision where a firm must decide whether to accept an order for a below-market price
What are important considerations for special orders?
(i) the increased revenues and variable costs from accepting the order
(ii) whether accepting the special order would affect other sales (e.g. other customers wanting the same discount)
(iii) whether any fixed costs would be affected (they usually don't since special orders are for firms with extra idle capacity)
What is a make-or-buy decision?
A business decision where a firm must decide whether to produce its own goods in-house or purchase them from another
What are important considerations for make-or-buy decisions?
(i) increased variable costs from producing in-house
(ii) decreased costs from unused factory capacity
(iii) whether the factory capacity that would be used to produce the goods can earn money some other way (e.g. renting it out, producing something else)
What is a scrap-or-rework decision?
A business decision to rework deficient inventory or dispose of it
What are important considerations for scrap-or-rework decisions?
(i) the salvage value of scrap material
(ii) the increased revenue to be gained from reworked inventory
What is a sell-or-process-further decision?
A business decision to either sell inventory after breaking it off from a manufacturing process, or processing it further
What are important considerations for sell-or-process-further decisions?
(i) manufacturing costs to process further
(ii) additional revenues from further processing
What are important considerations for business decisions to remove a product line or an entire division?
(i) product lines that individually incur losses but still recover fixed costs overall (i.e. unavoidable fixed costs)
(ii) how removing one product line might affect the sales of other product lines
What are two common approaches to establishing a product's price?
(1) contribution margin approach -- basing the price on the CM
(2) cost-plus pricing -- determining the cost of a product and then adding a % markup
If a firm wants a particular profit margin % on a given product, how does that relate to the markup % in determining its price?
The two are different: profit margin is a % of the product price, while a markup % is a % of the cost of the product prior to increasing it to its product price
% markup on cost = profit margin % / (100% - profit margin %)
What is an example of determining a product price from a profit margin %?
A product's total cost to the firm is $5 and the firm desires a profit margin of 20%
markup % on cost = 20% / (100% - 20%) = 25%
Cost of product = $5 x 125% = $6.25
What is predatory pricing?
Decreasing one's prices drastically in order to drive out competition and then increase prices from the monopoly one has just gained
Illegal due to antitrust laws
What is direct/variable costing?
A method of valuing inventory only using variable costs -- all fixed costs are considered period costs, not product costs
Can direct costing be used for financial reporting?
No, it cannot be used for financial reporting (or for taxes) -- only for internal reporting
How does direct costing differ from absorption costing?
Absorption costing includes all manufacturing costs in inventory, both variable and fixed
Absorption costing is also part of GAAP
How is income affected by the choice between direct costing and absorption costing?
Depends on how the production (i.e. increase in inventory) for the period compares to sales
-if production > sales, absorption costing will yield a higher income
-if production < sales, direct costing will yield a higher income
-if production = sales, both will yield the same income
Why do direct costing and absorption costing sometimes yield different incomes?
Under direct costing, all fixed costs are period costs, so all fixed costs incurred in the period will always be included in the income statement
Under absorption costing, all fixed costs are inventoried, so fixed costs will only be included in the income statement if those same goods are sold (and thus included in cost of goods sold)
Therefore, if production > sales, some of the fixed costs will not be included in the income statement, and so the profit/income for the year will be higher -- and vice versa if production < sales
How can a firm reconcile its direct-costing income with absorption-costing income?
Δ income = Δ inventory x fixed MOH per unit
This would effectively ensure that any differences between production and sales (which would result in different beginning and ending inventory balances for the year) are cancelled out
What are some advantages of direct costing?
(i) reflects the fact that fixed costs occur regardless of production level, not being altered by changes in production or inventory levels
(ii) ties net income more directly to sales
(iii) provides simpler accounting for inventory, since fixed costs don't need to be assigned to products
(iv) much more useful for CVP analysis (e.g. absorption costing cannot be used unless production quantity = sales quantity)
What are some disadvantages of direct costing?
(i) not GAAP
(ii) requires product costs and period costs to be separated into fixed and variable elements, which can be difficult
(iii) can lead to a neglect of fixed costs
How does direct costing affect the format of an income statement?
The income statement normally uses the "contribution margin format":
- variable costs
= contribution margin
- fixed costs
= operating income